a16z investors analyze the evolution history of stablecoins
Millions of people have traded trillions of dollars in stablecoins, but the category is still vaguely defined and understood.
Stablecoins are stores of value and media of exchange, often but not necessarily pegged to the U.S. dollar. People divide it into two dimensions: from under-collateralization to over-collateralization, and from centralization to decentralization.
This classification helps understand the relationship between technical structure and risk and eliminates misunderstandings about stablecoins. I will propose another helpful way of thinking based on this framework.
To understand the richness and limitations of stablecoin design, look to the history of banking: what works, what doesn’t, and why.
Like many products in cryptocurrencies, stablecoins may quickly reprise banking history, starting with simple banknotes and gradually expanding the money supply through complex lending mechanisms.
First, I will discuss the recent history of stablecoins and then take you through banking history to provide a useful comparison between stablecoins and banking structures.
Stablecoins provide users with an experience similar to bank deposits and banknotes—a convenient and reliable store of value, medium of exchange, and loan—but in an unbundled “self-custody” form.
Along the way, I will evaluate three types of tokens: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
Let’s dig a little deeper.
Some recent stablecoin history
Since the launch of USDC in 2018, the most widely adopted U.S. stablecoin has provided us with ample evidence to show which designs are successful and which are not.
Therefore, it is time to clearly define this area. Early users use fiat-backed stablecoins to transfer and save. Although the decentralized over-collateralized lending protocol has produced a useful and reliable stablecoin, its demand has been relatively muted. So far, consumers seem to prefer USD-denominated stablecoins over other (fiat or new) denominated options.
Certain categories of stablecoins have completely failed. While decentralized under-collateralized stablecoins are more capital efficient than fiat-backed or over-collateralized stablecoins, the most high-profile cases have ended in disaster. Other categories have yet to take shape: Yield stablecoins are intuitively promising – after all, who doesn’t like yield? — but they face user experience and regulatory hurdles.
Other types of USD-denominated tokens have also emerged, leveraging the successful product-market fit of stablecoins. Strategy-backed synthetic USD (described in more detail below) is a new product category that, while similar to stablecoins, does not actually meet important standards of security and maturity, and its higher-risk benefits are outweighed by DeFi Accepted by enthusiasts as an investment.
We’ve also witnessed the rapid adoption of fiat-backed stablecoins, popular for their simplicity and perceived security, while the adoption of asset-backed stablecoins has lagged behind, despite them traditionally accounting for the lion’s share of deposit investments . Analyzing stablecoins through the lens of traditional banking structures helps explain these trends.
Bank Deposits and U.S. Currency: A Little History
To understand how contemporary stablecoins mimic banking structures, it’s helpful to understand the history of U.S. banking.
Before the Federal Reserve Act (1913), and especially before the National Bank Act (1863-1864), different types of dollars were not treated equally.
(For those interested in learning more, the United States went through three central banking eras before establishing a national currency: the Central Bank Era [First Bank 1791-1811 and Second Bank 1816-1836], and the Free Banking Era [ 1837-1863], and the National Bank Era [1863-1913]. We tried almost everything.)
Before the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, deposits had to be specifically insured against bank risks. The "actual" value of bank notes (cash), deposits, and checks may vary depending on the issuer, ease of exchange, and reliability of the issuer.
Why is this happening? Because banks have conflicts between making profits and ensuring the safety of deposits.
In order to make profits, banks need to invest deposits and bear risks, but in order to ensure the safety of deposits, they need to manage risks and maintain sufficient cash reserves. Before the mid-to-late 19th century, different forms of money were believed to have different levels of risk, and therefore their actual value. After the implementation of the 1913 (Federal Reserve Act), the U.S. dollar came to be considered equivalent (in most cases).
Today, banks use dollar deposits to buy Treasury bonds and stocks, make loans, and engage in simple strategies such as market making or hedging, all of which are allowed under the (Volcker Rule).
The rules were introduced in 2008 to reduce the risk of insolvency by reducing speculation among retail banks. Lending is particularly important in banking and is how banks increase the money supply and increase the efficiency of capital in the economy.
Although the average bank customer may think that all of their money is held in a deposit account, this is not the case. However, due to federal regulation, consumer protections, widespread adoption, and improved risk management, consumers can treat deposits as a relatively risk-free overall balance.
Banks balance profits and risks in the background, and users are mostly unaware of what the bank does with their deposits, but they have confidence in the safety of their deposits even in times of economic turmoil.
Stablecoins provide users with many of the familiar experiences of bank deposits and banknotes—a convenient and reliable store of value, a medium of exchange, and a loan—but in an unbundled “self-custody” form.
Stablecoins will follow the example of their fiat currency predecessors. Applications will start with simple paper currencies, but as decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.
Looking at stablecoins from the perspective of bank deposits
Against this backdrop, we can evaluate three types of stablecoins from a retail banking perspective: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
Stablecoins backed by fiat currency
Fiat-backed stablecoins are similar to U.S. bank notes from the national banking era (1865-1913).
During this period, bank notes were bearer certificates issued by banks; federal regulations required that customers redeem these notes for equivalent amounts in greenbacks (such as certain U.S. Treasury bills) or other legal tender ("coins").
Therefore, although the value of a bank note may vary depending on the issuer's reputation, distance, and perceived solvency, most people trust bank notes.
Fiat-backed stablecoins operate on the same principles. They are tokens that users can redeem directly for a well-known, trusted fiat currency, but have similar limitations: While bank notes are bearer certificates that can be redeemed by anyone, the holder may not live in the country of issue Near the bank.
Over time, people came to accept that they could find someone willing to exchange bank notes for greenbacks or coins.
Likewise, users of fiat-backed stablecoins are increasingly confident that they can reliably find someone willing to exchange a dollar’s worth of high-quality fiat-backed stablecoins through Uniswap, Coinbase, or other exchanges.
Driven by regulatory pressure and user preferences, more and more users are turning to fiat-backed stablecoins, which account for more than 94% of the total stablecoin supply.
Circle and Tether dominate the issuance of fiat-backed stablecoins, together issuing more than $150 billion in U.S. dollar-denominated fiat-backed stablecoins.
So, why should users trust the issuers of stablecoins backed by fiat currencies? After all, stablecoins backed by legal tender are issued centrally, and it is easy to imagine a possible "run" on stablecoin redemptions.
To address these risks, fiat-backed stablecoins increase trust by being audited by reputable accounting firms. For example, Circle is regularly audited by Deloitte. The purpose of these audits is to ensure that stablecoin issuers have sufficient fiat currency or short-term Treasury debt reserves to cover any near-term redemptions, and that issuers have sufficient fiat currency collateral to back each stablecoin 1:1.
Verifiable proof of reserves and decentralized issuance of fiat stablecoins are both possible, but not yet a reality. Verifiable proof of reserves will increase audit transparency and are currently possible through means such as zkTLS (zero-knowledge transport layer security, also known as web proof), although still relying on a trusted centralized authority.
Decentralized issuance of fiat-backed stablecoins may be feasible, but faces significant regulatory challenges.
For example, to achieve decentralized fiat-backed stablecoin issuance, issuers need to hold U.S. Treasury bonds on the chain that have similar risk characteristics to traditional Treasury bonds. This is currently not feasible, but if implemented, it would further enhance user trust in fiat-backed stablecoins.
Asset-backed stablecoin
Asset-backed stablecoins originate from on-chain lending. They mimic the mechanism by which banks create new money through loans. New stablecoins issued by decentralized over-collateralized lending protocols like Sky Protocol (formerly MakerDAO) are backed by highly liquid collateral on-chain.
To understand how this works, consider a checking account. The money in a checking account is part of a complex system of lending, regulation, and risk management that creates new money.
In fact, most of the money in circulation, the so-called M2 money supply, is created through bank loans. While banks create money through things like mortgages, car loans, business loans, and inventory financing, lending protocols use on-chain tokens as collateral for loans, thereby creating asset-backed stablecoins.
This system of creating new money through loans is called fractional reserve banking, which officially began with the Federal Reserve Bank Act of 1913.
Since then, the fractional-reserve banking system has matured significantly, with major developments in 1933 (with the establishment of the FDIC), 1971 (when President Nixon ended the gold standard), and 2020 (when the reserve requirement ratio was reduced to Zero) has been significantly updated.
Each change gives consumers and regulators more trust in the system that creates new money through lending. Over the past 110 years, loans have created an ever-increasing share of the U.S. money supply, now accounting for the majority.
There's a reason consumers don't think about these loans when using dollars. First, funds held in banks are protected by federal deposit insurance. Second, despite major crises such as 1929 and 2008, banks and regulators have continuously improved their practices and processes to reduce risk.
Traditional financial institutions use three methods to safely issue loans:
For assets with liquid markets and rapid liquidation practices (margin lending)
Large-scale statistical analysis using bundling of a group of loans (mortgages)
Through thoughtful and customized underwriting (commercial lending)
Decentralized lending protocols still account for a small share of the stablecoin supply as they are in the early stages of their development.
The most representative decentralized over-collateralized lending protocol is transparent, well-tested and conservative in style. For example, Sky is the most famous collateralized lending protocol, and the asset-backed stablecoins it issues are based on on-chain, exogenous, low-volatility and highly liquid (easy to sell) assets.
Sky also has strict regulations on staking rates and effective governance and auction protocols. These features ensure that collateral can be safely sold even when conditions change, thus protecting the redemption value of the asset-backed stablecoin.
Users can evaluate mortgage lending agreements based on four criteria:
Transparency in governance
Ratio, quality, and volatility of assets backing stablecoins
Security of smart contracts
The ability to maintain loan mortgage rates immediately
Like the example of funds in a checking account, asset-backed stablecoins are new currencies created through asset-backed loans, but with lending practices that are more transparent, auditable, and easy to understand.
Users can audit the collateral backing asset-backed stablecoins, but can only rely on trust in bank executives’ investment decisions.
Additionally, the decentralization and transparency of blockchain can alleviate the risks that securities laws are designed to address.
This is critical for stablecoins because it means that truly decentralized asset-backed stablecoins may not be subject to securities laws. This analysis may only apply to asset-backed stablecoins that rely on digitally native collateral (as opposed to “real world assets”), as such collateral can be secured through autonomous protocols without relying on a centralized intermediary.
As more economic activity moves on-chain, we can expect two things: first, more assets will become candidates for collateral in lending protocols, and second, asset-backed stablecoins will take a larger share of on-chain currencies. Other types of loans may also eventually be issued securely on-chain, further expanding the on-chain money supply.
Still, users can evaluate assets supporting stablecoins, but that doesn’t mean every user will be willing to take on that responsibility.
Just as it took time for traditional bank lending to grow, regulators to reduce reserve requirements, and lending practices to mature, so too will on-chain lending protocols take time to mature. So it will take some time before asset-backed stablecoins can be used as easily as fiat-backed stablecoins.
Strategy-backed synthetic dollars
Recently, some projects have started offering $1 face value tokens that combine collateral and investment strategies. While these tokens are generally classified as stablecoins, the strategy-backed synthetic USD should not be considered a stablecoin. Here’s why.
Strategy-Backed Synthetic Dollars (SBSDs) give users direct exposure to actively managed trading risk. They are typically centralized, undercollateralized tokens combined with financial derivatives.
More specifically, SBSDs are U.S. dollar shares in open-end hedge funds, a structure that is not only difficult to audit but can also expose users to centralized exchange (CEX) risk and asset price volatility, especially during times of significant market volatility or When negative emotions persist.
These characteristics make SBSDs unsuitable for the primary purpose of stablecoins - a reliable store of value or medium of exchange. While SBSDs can be structured in a variety of ways, with varying risks and stability, they all provide a U.S. dollar-denominated financial product that may be included in an investment portfolio.
SBSDs can be built on a variety of strategies, such as basis trading or participating in yield protocols such as re-staking protocols that help secure Active Verification Services (AVSs).
These projects typically allow users to earn gains on cash positions by managing risk and reward. Projects can generate yield-based SBSD through yield management risk, including assessing penalty risk on AVSs, looking for higher yield opportunities, or monitoring for reversals in basis trades.
Before using any SBSD, users should have a thorough understanding of its risks and mechanisms, just like any other new tool. DeFi users should also consider the consequences of using SBSDs in DeFi strategies, as there could be severe knock-on effects if decoupled.
Derivatives that rely on price stability and consistent returns can suddenly become unstable when an asset decouples or suddenly loses value relative to the asset it tracks. However, when a strategy contains centralized, closed-source, or unauditable components, it can be difficult or even impossible to assess and underwrite its risks. To insure a risk, you must understand what you are insuring.
While banks do run simple strategies through deposits, these strategies are actively managed and represent a small proportion of overall capital allocation. These strategies struggle to support stablecoins because they require active management, which makes it difficult for these strategies to be reliably decentralized or auditable.
SBSDs expose users to greater concentrations of risk than allowed in bank deposits. Users have reason to be suspicious if their deposits are held in this manner.
In fact, users have been wary of SBSDs. Although SBSDs are popular among risk-seeking users, not many people actually trade them. Additionally, the U.S. Securities and Exchange Commission (SEC) has taken enforcement action against issuers of “stablecoins” that are effectively like shares in investment funds.
Stablecoins have become widespread. The total number of stablecoins used in global transactions has exceeded $160 billion. They are mainly divided into two main categories: fiat-backed stablecoins and asset-backed stablecoins. Other U.S. dollar-denominated tokens, such as strategy-backed synthetic dollars, do not meet the definition of a stablecoin for trading or storing value, despite their increased awareness.
Banking history is a good reference for understanding the category – stablecoins must first be organized around a clear, understandable and easily convertible bank note, much like how Federal Reserve bank notes gained recognition in the 19th and early 20th centuries Same.
Over time, we can expect the number of asset-backed stablecoins issued by decentralized over-collateralized lenders to increase, just as banks increase the M2 money supply through deposit lending. Finally, we can expect DeFi to continue to grow, not only by creating more SBSDs for investors, but also by increasing the quality and quantity of asset-backed stablecoins.
But this analysis – useful though it may be – can only take us so far. Stablecoins have become the cheapest way to send dollars, which means that in the payments industry, stablecoins have an opportunity to reshape the market structure, providing existing companies, especially startups, with a new platform for frictionless and cost-free payments. Building provides opportunity.
Acknowledgments: Special thanks to Eddy Lazzarin, Tim Sullivan, Aiden Slavin, Robert Hackett, Michael Blau, Miles Jennings, and Scott Kominers, whose thoughtful feedback and suggestions made this article possible.
Sam Broner is a partner on the a16z crypto investment team. Prior to joining a16z, Sam was a software engineer at Microsoft, where he was a founding team member of Fluid Framework and Microsoft Loop.
Sam also attended the MIT Sloan School of Management, where he worked on Project Hamilton at the Federal Reserve Bank of Boston, led the Sloan Blockchain Club, directed Sloan’s first AI Summit, and is recognized for creating entrepreneurial communities. and received the Patrick J. McGovern Award from MIT. You can follow him on the X platform @SamBroner.
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